Has the Rally Gotten Ahead of Itself?

The stock market has buoyed the bulls and confounded the bears with its exuberant gains since the March bottom. From its closing low of 677 on March 9 through August 27, Standard & Poor's 500-stock index has advanced a stunning 52%.

The gains have been fueled largely by the realization that the global financial system has avoided a meltdown and by growing confidence that the recession is over. But the market can only go so far on the strength of those developments. So we took the S&P 500's recent crossing of the 1000 mark -- a figure last seen in November 2008 -- as an opportunity to ask some of our favorite value managers whether they think the rally has legs and how they're investing now. Here are their answers:

Is the market overvalued? Yes

Jeremy Grantham, chairman of GMO Funds
"I'm pretty confident that the S&P 500 is moderately overpriced today, compared with its fair value of about 880. The big opportunity was in March, when stocks were the cheapest they'd been in 20 years. Since then there has been a very speculative rally -- one that has had nothing to do with earnings prospects. This rally was the last hurrah of the simple-minded euphoria of the past 20 years.

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"From today's prices, the S&P 500 is likely to return the inflation rate plus four to five percentage points per year, on average, over the next seven years. Those are not bad returns, but with the S&P 500 over 1,000 I think investors should take 5% off the table, with a battle plan that specifies the lower prices at which they will reinvest. It's very likely that you'll have a chance, in the next 12 months, to get back into the market at much lower prices.

"High-quality blue-chip stocks have lagged badly in the recent speculative rally. In a market that's moderately expensive, these stocks are still moderately cheap, and they're well positioned for the seven lean years to come. If you have to put more money into the market at these prices, you should only be buying such high-quality stocks."

Is the market overvalued? A little

Robert Wyckoff and Thomas Shrager, co-managers of Tweedy, Browne funds
"From October of last year through March of this year, picking stocks was like shooting fish in a barrel. The market has moved very far, very quickly, since then, and there's no question that if you're a value investor, your idea flow has slowed. At 1000, the S&P 500 is probably a little expensive compared with past earnings and reasonably priced compared with the consensus estimate for future earnings-assuming that the earnings forecasts are reasonable.

"We're not shooting fish in a barrel anymore, but if you're selective, there are still attractive opportunities. Emerson Electric (EMR) is a high-quality, global, industrial company that has rarely become cheap enough for us, as deep value investors, to own. But we've been able to buy it for about $33 a share. [The stock closed at $37.43 on August 27]. We think the stock is worth at least $40, based on normalized earnings, and it yields almost 4%.

"Similarly, we haven't typically owned commodity companies because projecting the prices of oil and gas is so difficult. But ConocoPhillips (COP) has a strong balance sheet and a good credit rating. It currently sells for a huge discount to its intrinsic value, which we estimate at about $100 per share."

Is the market overvalued? Prices are rational

Ralph Shive, co-manager of Wasatch 1st Source Income Equity
"If you compare the S&P 500 to analysts' 2010 earnings estimate of $65 per share, then the market is trading for about 15 times future earnings. Considering the low interest-rate environment, I think that's a fair valuation. Plus, investors are concerned with more than just earnings. The S&P 500 currently yields 2%, which is better than the basically 0% you can earn in a money-market fund.

"I think the S&P 500 could return about 7% per year, on average, over the next three to five years, with its dividend yield contributing 2% and price appreciation adding 5%. But that's not a roaring bullish forecast. I don't think we'll return to the market's October 2007 highs anytime soon. Unemployment will stay high for the next few years and taxes will increase, both of which will pinch consumers' disposable income and hurt corporate earnings.

"Currently, I have the mutual fund structured like a barbell, with overweightings both in stable defensive companies and more-volatile cyclical companies. It is overweight on consumer-staple companies, such as McKesson (MCK), Johnson & Johnson (JNJ) and Wal-Mart (WMT). But it's also overweight on some economically sensitive companies in the technology, industrial and commodity sectors, such as Fluor (FLR), Schlumberger (SLB) and Texas Instruments (TXN)."

Matthew McLennan, co-manager of First Eagle Global
"It's worth standing back and comparing where we are now, with the S&P 500 around 1,000, to where we were a couple of years ago. In 2007, the market's price-earnings ratio was about 50% higher than it is today, earnings were above their long-term trend, and energy prices were high. Today, stocks are one-third cheaper than they were two years ago, earnings are below the long-term trend, energy prices have come down, and there is a much more favorable policy backdrop. So, although stocks are not as cheap as they were in March, prices are not irrational.

"Compared with other asset classes, we see stocks as among the best of a bad group of choices. Over the next five years, U.S. stocks could achieve average annual returns in the high single digits, but many things could change that. One positive is that the economy has shrunk to a smaller, healthier kernel from which it can grow again.

"Since March, we've witnessed a dash to trash. Right now we're looking for high-quality, stable businesses that may be beneficiaries in a muted recovery and that have lagged since March. In particular we like commercial-services companies Cintas (CTAS) and Omnicom Group (OMC). They have stable revenues, their businesses are not capital intensive, and their stocks are available at reasonable prices. We also have 20% of the portfolio in cash and gold, as dry powder for when we see more-compelling opportunities."

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